The Economist explains – Why the world is addicted to debt

19.05.2015 04:05

The Economist explains

Why the world is addicted to debt

May 17th 2015, 23:50BY P.F.

DEBT is the “vital air of modern commerce”. Those words were spoken by Daniel Webster, an American senator, in 1834, when America’s bond market was still in its infancy. Today the world is crippled by too much debt. The borrowings of global households, governments, companies and financial firms have risen from 246% of GDP in 2000 to 286% today. Since the financial crisis began in 2007, debt-to-GDP has risen in 41 of 47 big economies tracked by McKinsey, a consultancy firm. For every extra dollar of output, the world cranks out more than a dollar of debt. Beyond a certain point an ever thicker mesh of debt contracts is bad for growth, making firms and households vulnerable to shocks and disruptive defaults. Why is the world addicted to borrowing?

The lust for debt has two underlying causes. First, the tax system gives perks to borrowers. Interest payments on mortgages are tax deductible in about half of rich countries and some emerging ones, for example India. And around the world firms can deduct interest costs against their taxable profit. That creates an incentive to issue debt instead of equity (for example shares). Only a quarter of the world’s stock of assets is now comprised of shares, which are far more flexible than debt because dividend payments to investors can be cut without causing a default. The second underlying cause is the wiring in humans’ brains. People over-estimate the safety of the fixed payments that debt offers: like a corset, it masks nature’s wobbles. They also tend to assume that asset prices, particularly of houses, will rise. Using debt to buy rising assets boost profits.

Our global debt interactive

Three powerful global trends have magnified the effects of tax and psychology. First, big exporters such as China have built up reserves that must be invested abroad. They prefer debt because buying lots of shares in foreign firms can be controversial. Some 75% of the rise in foreign ownership of American securities in 2004-08 was in bonds, mainly mortgage and corporate securities. Second, inequality has not helped. The rich must recycle their savings into the financial system. Those in need of capital are often poor and in practice debt is the only way to funnel money to them—you can’t buy shares in a subprime household. The third accelerant is the finance industry. Its impulse is to manufacture debts owed by others in order to generate fees. Too-big-to-fail guarantees give banks an incentive to borrow on their own balance-sheets as well.

There is no easy way to wean the world from debt. But a starting point is tax reform. The perks for debt reflect decisions made over a century ago by politicians who could not have imagined the level of borrowing today. Britain made interest deductible for firms in 1853. Tax breaks for debt in Europe, America and Britain were worth 2-5% of GDP in 2008—more than was being spent on defence. Because interest rates are so low, the subsidy has dropped to 1-2% today. The right time for governments to act is now. As interest rates rise again, the value of the subsidy will grow, and the incentive to borrow will get bigger.

Dig deeper:Why subsidies that make borrowing irresistible need to be phased out (May 2015)Most Western economies sweeten the cost of borrowing (May 2015)